Why emerging markets have underperformed – or have they?

By Brian Tycangco

Stocks are arguably the biggest creator of wealth in modern history. But that's only true if you buy the right stock… and the right markets… at the right time.

The S&P 500 has risen 262 percent since October 22, 2008. That's equivalent to an average annual return of 26.2 percent - a whole lot more than real estate, bonds and other assets.

But as shown below, every other major stock market and region has performed worse than U.S. shares over the past 10 years. European shares are up an average of 5.5 percent per year. Latin America is up 7.5 percent. Asia ex-Japan is up nearly 16 percent per year over the past decade.

What stands out here is that less-developed markets have sharply underperformed. The MSCI Emerging Markets Index (which includes Brazil, Chile, China, India, Russia and 17 other smaller markets) has gained just 7.9 percent a year, on average, over the last 10 years. And frontier markets - which aspire to emerge into emerging market status - have done even worse, returning just 1.4 percent per year.

However, the past decade is only part of the story. Looking at a longer time horizon, these markets have actually performed very well - since the beginning of the 21st century.

Outperforming the S&P 500 since 2000

The chart below shows the performance of the MSCI Emerging Markets Index since the start of 2000 versus the MSCI World Index, the MSCI Asia ex-Japan Index and the S&P 500 Index.

Over that period, the MSCI Emerging Markets Index has gained 218 percent. That compares with a 197 percent increase in the MSCI Asia ex-Japan Index, 165 percent for the S&P 500 Index and a 126 percent advance in the MSCI World Index.

So while U.S. markets have done well since the bottom of the global economic crisis in 2008, emerging markets have proven to be the most rewarding markets for investors over the longer term since 2000 - a period that includes the global economic crisis.

Why?… a few reasons…

Lies, even worse lies, and statistics… The popular quotation about the persuasive power of numbers - widely attributed to Victorian-era British Prime Minister Benjamin Disraeli - of course plays a role here. Emerging markets exploded in the mid 2000s, and that period of outperformance bolsters their 18-year (since 2000) performance. Emerging markets also sharply outperformed in the several years after 2008. But the underperformance during certain periods has hurt performance over the past decade. Interpreting performance is in part a function of how the figures are sliced.

Emerging market economies grow faster. The strong economic growth performance of emerging markets has a lot to do with a rapidly growing middle class, but also a favourable demographic that's characterised by a large and young workforce (we've written about this here and here). As the largest of the emerging markets, China's booming economy has played a central role in lifting the emerging markets' stock performance. Its economy has expanded at a compound annual growth rate (CAGR) of 9.5 percent since 2000 (in real terms).

But it's not just China. India has also grown by 7.9 percent a year during the same period, while Brazil has grown 3.7 percent, the Philippines by 5.6 percent, Turkey by 4.5 percent and Thailand by 4.8 percent. That compares with a CAGR of just 2.0 percent for the United States, 1.2 percent for Germany and 0.8 percent for Japan. And where economies are growing fastest, earnings - and share prices - usually grow alongside it.

Emerging markets are still emerging. Whether you're talking about capital markets (i.e., stock exchanges), consumer spending, infrastructure or government regulation, emerging markets are far less developed than first-world economies. And they're also changing rapidly.

For example, partly because of lack of investor protections, limited transparency and restricted flow of foreign investment in China's stock markets, the country's stock market capitalisation-to-GDP ratio (71 percent as of the end of 2017) remains well below that of the U.S. (165 percent).

By this measure, China's stock market is undervalued (we've written about this popular indicator in the past here). But it also can be a reflection of the level of confidence investors have in a country's financial markets, which have largely been closed and tightly regulated in China.

But China's President, Xi Jinping, is trying to change that. He's made the liberalisation of financial markets a cornerstone of his development programme, including a China mainland-Hong Kong stock connect programme allowing individual investors on each side to trade shares in the opposite market through their local brokers under a quota scheme.

Meanwhile, China's central bank governor, Yi Gang, announced in April plans to relax foreign ownership limits in financial companies in China's trust, leasing, auto financing, money brokerage and consumer finance sectors by the end of 2018.

These sorts of changes drive long-term investment in emerging economies. China's investment environment has opened up dramatically in recent years - and that's permitted an enormous influx in investment.

Emerging markets are cheap. As a whole, emerging market economies offer better value than developed markets on practically every metric (i.e., price-to-earnings, price-to-book value and price-to-sales).

For example, emerging markets currently trade at a price-to-earnings (P/E) ratio of 13.9 times compared with 18.1 times for developed markets. That's a 23 percent discount. And on a price-to-book (P/B) value basis, emerging markets trade at 1.7 times versus 2.2 times for developed markets (also a 23 percent discount).

When compared to the U.S., emerging markets are even cheaper. The U.S. market is now trading at a P/E ratio of 21.7 times and a P/B ratio of 3.4 times. That means emerging markets are trading at 64 percent and 50 percent discounts to the U.S. market P/E and P/B ratios, respectively.

Of course, there are reasons why emerging markets usually trade at far lower valuations than developed markets. They're generally riskier, with volatile growth in their economies, while others suffer from a constantly changing political landscape. And just because emerging markets are trading at discounts, it doesn't mean those discounts will evaporate anytime soon.

But historical data shows that it pays to have a diversified portfolio that contains exposure to emerging markets. This is even more important today given that most developed markets, particularly the U.S., are at their most expensive levels in a decade.

So it makes sense to allocate a portion of your portfolio to emerging markets. One way to invest is through the iShares MSCI Emerging Markets ETF (Exchange: New York; ticker: EEM). EEM is an exchange-traded fund that's designed to track the investment results of the MSCI Emerging Markets Index.

 

Brian Tycangco
Brian Tycangco is an Editor and Investment Analyst with Stansberry Churchouse Research, an independent investment research company based in Singapore and Hong Kong that delivers investment insight on Asia and around the world. He's been working in the financial world since 1995 and has carved out a reputation as "Master Stock Picker". He's seen just about everything there is to see in these markets, met with the leading CEOs of every industry in Asia, and knows the ins and outs of doing business and making money there. Brian has been a stock broker at a large Asian trading house, an equities analyst for a major European investment bank, as well as editor and chief investment strategist for one of the longest-running Asian investment newsletters in the world. Click here to sign up to receive the Asia Wealth Investment Daily in your inbox every day, for free.

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